Commentary: Equities rally, but central banks ready to ruin the party
Central banks have been caught napping and are shifting to a more aggressive interest rate tightening cycle. The potential for a policy mistake is high, but with inflation shifting to its highest level since the 70’s, there is little policy flexibility.
Risk rebounds from oversold levels
March was a tough month for investors with equities, bonds and even some haven currencies selling off rather dramatically. Global equities fell over 6%, US 10-year treasuries fell 5.5% and the JPY fell over 7% peak to trough for the month. Most of the drop in risk assets was due to the escalating conflict in Ukraine and the inflationary impulse emanating from the resulting commodity price squeeze. With global bonds delivering their worst quarter on record, these moves served as a reminder of how the equity-bond correlation cannot always be relied upon and can turn positive during inflationary regimes. However, as the market became less fixated on the conflict, global equities staged an impressive rally, gaining over 10% trough to peak, ending the month up 1.9% in USD terms.
The sell-off in early March was due for a rebound. Typically, geopolitical events rock markets but are soon forgotten, with the average S&P 500 geopolitical drawdown over the past 100 years being around 6% and recovering to flat in 11 days. The relative strength indicator (RSI) for global equities fell below 30 (a technical buy signal), fund manager equity positioning was one standard deviation below its long-term average and the bull/bear ratio slipped below one, implying investors were very bearish. This kind of positioning always leads to a counter trend rally as these extremes wash out and fear of geopolitical escalation eventually gives way to unfortunately ‘living with’ the conflict. The one small but very important caveat is that once markets recover from geopolitical events, the focus of investors shifts back to the prevailing macroeconomic backdrop.
Risks have not changed, complacency growing
To put the recent rally into context, the percentage gain and speed of this counter trend rally ranked in the 99.5th percentile of snapbacks during bull markets since the 1920s and the 98th percentile of bear market rallies. Essentially the market has discounted the Ukraine conflict and is instead focusing on above trend global growth and the continuation of strong earnings from corporates. However, we believe this view is complacent. While the conflict in Ukraine is a humanitarian tragedy which increases the likelihood of potential black swan events, the main story from a macroeconomic perspective is persistently high inflation and an increasingly aggressive global monetary tightening cycle. The markets believe central banks can engineer a soft landing, despite little evidence they’ve ever been successful at doing so.
Inflation remains stubbornly high across the world. US CPI has hit 7.9% year-on-year, the highest since the 1970s and even perpetually stagnant Europe has seen inflation rise to 7.5%. US Federal Reserve members have been out in force, highlighting their desire to tighten monetary policy to rein in inflation. December 2022 Eurodollar futures are pricing in a cash rate of 3% by the end of the year. From a liquidity perspective, the US shadow Fed Funds rate has already tightened by 2% (from -1.85% to +0.2%) and that’s before the Fed embarks on aggressive balance sheet reduction.
Not only does this put downside pressure on growth and the likelihood of a hard landing, but inflation also tends to erode company profits and reduce margins. We are already starting to see the start of increasing wages and input costs in the US and margins are already at all-time highs. US corporate profits as a percentage of GDP (both pre- and post-tax) are at the highest levels of the past 50 years. While consumer balance sheets are in excellent condition, real wages have collapsed and with that, consumer confidence has fallen. While our indicators still show minimal chance of a recession in the US (so far), the yield curve has inverted, the economy is slowing, and the Fed has been too slow in its response and now is looking to hike aggressively. Recall that the economy doesn’t die of old age, it is typically killed by the Fed overtightening.
Higher yields are starting to create some value in fixed income, but it is perhaps too early to start aggressively building duration risk. Inflation remains a problem, and central banks have only just started their rate hiking cycle. Equity valuations look more reasonable, but they are not reflecting the potential for a new inflationary regime. Since 1900, the average price-to-earnings ratio (PE) of the US equity market when inflation is around 8% is around 10 times, which is less than half the current US PE of 22. While we don’t believe we will stay at these heightened levels of inflation, a CPI band of 2-4% has historically seen US equities average PE of 16 times, implying the potential for further derating before this cycle is over.
Positioning remains defensive
Given the growing risks of an economic slowdown, an increasingly hawkish Fed and perhaps an inflationary regime shift, we have not bought into this relief rally. Like in February, we used the recent bounce to reduce risk even further, bringing equities down from 25% to 22% on a delta adjusted basis. Our defensive positioning has helped insulate the fund, which is down 3% (pre-fees) year to date, which compares favourably to the MSCI All Country World Index which is down 8% in AUD terms and global aggregate bonds down almost 5% in hedged AUD terms. We continue to hold elevated levels of cash of over 20% and moderate levels of duration of 1.75yrs. While periods of regime shifts can be volatile, with both risk assets and safe havens selling off, this volatility helps embed some more attractive risk premium into assets, allowing a portfolio reset to gain more attractive long-term returns. We just don’t believe we are there yet.
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